NCERT Solutions for Class 12 Macro Economics Chapter 3 – Money and Banking

NCERT Solutions for Class 12 Macro Economics Chapter 3 – Money and Banking

NCERT Solutions are invaluable resources for students preparing for the CBSE Class 12 Economics Board examinations. These solutions are meticulously compiled by subject matter experts with extensive experience in the field. This chapter serves as a brief of Money and Banking

Access NCERT Solutions for Class 12 Economics Chapter 3 – Money and Banking

NCERT Macroeconomics Solutions Class 12 Chapter 3 – Money and Banking

Textual Questions and Answers

Q. 1. What is a barter system? What are its drawbacks?

Ans.

The barter system is one of the oldest methods of trade and was used long before money was invented. It involves exchanging goods or services directly for other goods or services without the use of currency. For example, a farmer might trade a basket of apples with a tailor in exchange for a piece of clothing.

Drawbacks of the Barter System:

1. Lack of a Common Measure of Value: It’s challenging to determine how much one good or service is worth in terms of another. For example, how many apples are equivalent to a shirt?
2. Double Coincidence of Wants: Both parties must want what the other has to offer at the same time. This coincidence is not always easy to find.
3. Divisibility Issues: Some goods are not easily divided or broken down into smaller parts. For instance, if a cow is being exchanged for smaller items, it can’t be split without losing its value.
4. Storage of Wealth: It’s difficult to store and preserve wealth in the form of goods. Perishable items like food can spoil, and other goods can degrade over time.
5. Transport and Portability: Large or heavy goods are challenging to transport and trade over long distances.
6. Lack of Standardization: Each item traded has unique characteristics, and there isn’t a standard measure of quality, making fair trades harder to achieve.

Modern Relevance:

While the barter system isn’t commonly used in modern economies, it can still be found in certain communities and in times of economic crisis when currency may lose its value or become scarce. Some modern online platforms facilitate barter exchanges, leveraging technology to overcome traditional drawbacks.

Q. 2. What are the main functions of money? How does money overcome the shortcomings of a barter system?

Ans.

Sure! Let’s break it down.

Main Functions of Money:

1. Medium of Exchange: Money is accepted as a common form of payment for goods and services, simplifying trade compared to bartering.
2. Unit of Account: It provides a standard measure of value, making it easier to compare the worth of different goods and services.
3. Store of Value: Money can be saved and retrieved in the future, maintaining its value over time.
4. Standard of Deferred Payment: It allows for future payments of debt, enabling transactions that involve credit.

How Money Overcomes Barter System Shortcomings:

1. Common Measure of Value: Money provides a consistent value measure, eliminating the challenge of determining the worth of one good in terms of another.
2. Coincidence of Wants: With money, you don’t need both parties to want what the other has. You can sell your goods for money and use that money to buy what you need.
3. Divisibility: Money can be easily divided into smaller units (like coins or smaller bills), making it practical for transactions of any size.
4. Storage of Wealth: Money is durable and easier to store without losing value, unlike perishable goods in a barter system.
5. Transport and Portability: Money is compact and lightweight, making it easy to carry and trade over long distances.
6. Standardization: Money is uniform, ensuring consistent quality and value, which simplifies trade and builds trust in transactions.

Summary:

Money acts as a practical tool that makes trade easier and more efficient by addressing the limitations of the barter system. It provides a standard and widely accepted way to measure, store, and exchange value, facilitating smoother economic interactions.

Q. 3 What is transaction demand for money? How is it related to the value of transactions over a specified period of time?

Ans.

Transaction Demand for Money:

Transaction demand for money refers to the amount of money people need to carry out their day-to-day transactions. It’s the money kept on hand to purchase goods and services, pay bills, and meet other regular expenses. This demand arises because money is needed for routine activities, like buying groceries or paying for transportation.

Relationship to the Value of Transactions:

The transaction demand for money is directly related to the total value of transactions over a specified period. Here’s how:

1. Higher Transaction Volume: When the volume of transactions increases, people need more money to complete these transactions. For example, during festive seasons, people might spend more on gifts, food, and travel, leading to higher transaction demand.
2. Price Level: If the prices of goods and services rise, people need more money to buy the same items. This increase in prices also raises the transaction demand for money.
3. Frequency of Transactions: The more frequently people engage in transactions, the higher the demand for money. For instance, if someone shops daily rather than weekly, they would need more money readily available.

Formula (Simplified):

The transaction demand for money can be represented by the equation:

Md = k x times PY

where:

• Md is the demand for money.
• k is a constant that represents the proportion of income held as money.
• P is the price level.
• Y is the real income or real GDP.

This formula shows that the demand for money is proportional to the total value of transactions (represented by PY, where P is the price level and Y is the real income).

Summary:

Transaction demand for money is crucial for facilitating everyday transactions and is influenced by the total value of goods and services exchanged over time. An increase in transaction volume, price levels, or transaction frequency leads to a higher demand for money.

Q. 4. What are the alternative definitions of money supply in India?

Ans.

In India, the money supply is measured using different definitions that categorize money based on its liquidity. These definitions are known as monetary aggregates. Here’s a brief overview suitable for a class 12 student:

Alternative Definitions of Money Supply:

M1 (Narrow Money):

• Components:
  • Currency with the public (coins and paper currency)
  • Demand deposits with banks (current and savings accounts)
• Characteristics: This is the most liquid form of money and can be easily used for transactions.

M2:

• Components:
  • M1
  • Savings deposits with post office savings banks
• Characteristics: Adds a slightly less liquid component compared to M1 but still relatively easy to convert to cash.

M3 (Broad Money):

• Components:
  • M1
  • Time deposits with banks (fixed deposits and recurring deposits)
• Characteristics: A broader measure that includes less liquid forms of money, such as time deposits, which cannot be immediately accessed without penalty.

M4:

• Components:
  • M3
  • Total deposits with post office savings banks (excluding National Savings Certificates)
• Characteristics: The broadest measure, including all components of M3 along with deposits in post office savings banks, providing a comprehensive view of the money supply.

Summary:

Each definition, from M1 to M4, adds progressively less liquid forms of money to the total, providing different levels of insight into the money supply in the economy. M1 is the most liquid, while M4 gives a broader picture by including various types of deposits.

Feel free to ask if you need any further explanation or examples! 😊

Q. 5. What is a ‘legal tender’? What is ‘fiat money’?

Ans.

Legal Tender:

Legal tender refers to money that must be accepted if offered in payment of a debt. It is recognized by the legal system of a country as valid for meeting financial obligations. For instance, in India, the Indian Rupee (₹) is the legal tender. If someone owes you money, they can settle the debt by paying you in rupees, and you must accept it.

Fiat Money:

Fiat money is a type of currency that does not have intrinsic value and is not backed by a physical commodity like gold or silver. Instead, its value comes from the trust and confidence that people have in the government that issues it. The government declares it as legal tender, which means it must be accepted for all payments within the country.

Key Points:

• No Intrinsic Value: Fiat money does not have value on its own. A 500-rupee note is worth 500 rupees because the government says so, not because of the paper it’s printed on.
• Government Backing: Its value is based on the authority and stability of the issuing government.
• Example: Most modern currencies, including the Indian Rupee (₹), US Dollar ($), and Euro (€), are examples of fiat money.

Summary:

• Legal Tender: Money that must be accepted for payment by law.
• Fiat Money: Currency with no intrinsic value, backed by the trust in the issuing government.

Q. 6. What is High Powered Money?

Ans.

High Powered Money (H)

High Powered Money, also known as the monetary base or reserve money, is the total amount of currency in circulation plus the reserves held by commercial banks with the central bank. It’s called “high powered” because it has a significant influence on the total money supply in the economy.

Components of High Powered Money:

1. Currency in Circulation: This includes all paper money and coins held by the public and businesses.
2. Reserves with the Central Bank: This includes the deposits that commercial banks hold with the central bank (like the Reserve Bank of India).

Formula:

High Powered Money (H) can be represented by the formula:

H = C + R

where:

• C is the currency in circulation.
• R is the reserves held by commercial banks with the central bank.

Importance:

High Powered Money is crucial because it forms the base on which the entire money supply is built. Through the process of fractional reserve banking, commercial banks can create more money by lending out a portion of their deposits, thus expanding the money supply.

Summary:

High Powered Money is the foundation of the money supply in the economy, consisting of currency in circulation and reserves held by banks with the central bank. It plays a vital role in determining the overall money supply and influencing economic activity.

Q. 7. Explain the functions of a commercial bank.

Ans.

Sure! Commercial banks play a crucial role in the economy by providing various services to individuals, businesses, and the government. Here are the main functions of a commercial bank:

Functions of a Commercial Bank:

1. Accepting Deposits:

• Savings Accounts: Banks allow individuals to deposit their money in savings accounts, earning a small interest.
• Current Accounts: Businesses often use current accounts for frequent transactions, though these accounts usually don’t earn interest.
• Fixed Deposits: Banks offer fixed deposits, where money is kept for a specified period at a higher interest rate.

1. Providing Loans and Advances:

• Personal Loans: Individuals can borrow money for personal use, such as buying a car or paying for education.
• Business Loans: Banks lend money to businesses for various purposes like expansion, purchasing equipment, or meeting operational costs.
• Cash Credit and Overdrafts: Businesses can withdraw more money than they have in their accounts, up to a certain limit, to meet short-term needs.

1. Credit Creation:

• By lending out a portion of the deposits they receive, banks create credit, which helps in increasing the overall money supply in the economy.

2. Agency Functions:

• Payment and Collection of Cheques: Banks help customers collect and pay cheques.
• Fund Transfers: Banks facilitate the transfer of funds from one account to another, both within the same bank and between different banks.
• Standing Instructions and Direct Debits: Banks can set up automatic payments for bills and other regular expenses on behalf of customers.

3. Investment Services:

• Banks offer investment opportunities like mutual funds, government bonds, and other financial instruments to customers, helping them grow their wealth.

4. Foreign Exchange Services:

• Banks provide foreign exchange services, allowing individuals and businesses to convert one currency into another, facilitating international trade and travel.

5. Safe Custody:

• Banks offer safe deposit lockers for customers to store valuables like jewelry and important documents securely.

6. Financial Advice:

• Banks provide financial advice and consultancy services to help customers make informed decisions about savings, investments, and loans.

Summary:

Commercial banks serve as intermediaries between depositors and borrowers, providing a wide range of services like accepting deposits, lending money, facilitating payments, and offering investment opportunities. They play a vital role in the functioning of the economy by ensuring the smooth flow of money and credit.

Q. 8. What is money multiplier? What determines the value of this multiplier?

Ans.

Sure! Here’s a simplified explanation of the money multiplier, suitable for class 12 students:

Money Multiplier:

The money multiplier is a concept that shows how much the total money supply in an economy can increase based on the amount of money that banks hold in reserves.

Formula:

The money multiplier (MM) can be calculated using the formula:
MM = 1/{LRR

where:
LRR stands for Legal Reserve Ratio, which is the percentage of deposits that banks are required to keep as reserves and not lend out.

Determinants of the Money Multiplier:

(1) Legal Reserve Ratio (LRR):

• If the RRR is lower, banks can lend out more of their deposits, leading to a higher money multiplier.
• If the RRR is higher, banks must hold more reserves, resulting in a lower money multiplier.

(2) Currency Drain Ratio:

• This is the portion of money that people prefer to hold as cash instead of depositing in banks. A higher currency drain ratio means less money is available for banks to lend, reducing the money multiplier.

(3) Excess Reserves:

• Sometimes, banks may hold more reserves than required. If banks keep more excess reserves, the money multiplier decreases because there is less money available for lending.

Summary:

The money multiplier helps us understand how the total money supply in an economy can grow based on the reserves held by banks. It is influenced by the required reserve ratio, the currency drain ratio, and excess reserves. A higher money multiplier means more money is being created in the economy, while a lower multiplier means less money creation.

Q. 9. What are the instruments of monetary policy of RBI?

Ans.

Instruments of Monetary Policy of RBI:

The Reserve Bank of India (RBI) uses several instruments to control the supply of money in the economy and maintain economic stability. Here are the main instruments of monetary policy:

(1) Open Market Operations (OMOs):

• The buying and selling of government securities in the open market to regulate the money supply.
• Buying Securities: Increases the money supply by injecting liquidity into the banking system.
• Selling Securities: Decreases the money supply by absorbing liquidity from the banking system.

(2) Repo Rate and Reverse Repo Rate:

• Repo Rate: The rate at which RBI lends money to commercial banks. Increasing the repo rate makes borrowing more expensive, reducing the money supply. Lowering the repo rate makes borrowing cheaper, increasing the money supply.
• Reverse Repo Rate: The rate at which RBI borrows money from commercial banks. Increasing the reverse repo rate encourages banks to park more funds with RBI, reducing the money supply. Lowering it has the opposite effect.

(3) Cash Reserve Ratio (CRR):

• The percentage of a bank’s total deposits that must be kept with the RBI as reserves.
• Higher CRR: Reduces the money supply by requiring banks to keep more money as reserves.
• Lower CRR: Increases the money supply by allowing banks to lend more money.

(4) Statutory Liquidity Ratio (SLR):

• The percentage of a bank’s total deposits that must be maintained in the form of liquid assets like cash, gold, or government securities.
• Higher SLR: Reduces the money supply by limiting the amount of money banks can lend.
• Lower SLR: Increases the money supply by allowing banks to lend more.

(5) Bank Rate:

• The rate at which RBI lends to commercial banks without any security. It is similar to the repo rate but typically used for long-term loans.
• Changes in the bank rate affect the money supply and influence overall interest rates in the economy.

(6) Marginal Standing Facility (MSF):

• A window for banks to borrow from the RBI in emergencies when they face a shortfall in liquidity.
• The MSF rate is usually higher than the repo rate to discourage banks from using this facility unless necessary.

(7) Liquidity Adjustment Facility (LAF):

• A tool used to manage liquidity and short-term interest rates. It includes repo and reverse repo operations.
• Helps in balancing the liquidity in the banking system on a daily basis.

Summary:

The RBI uses various monetary policy instruments like open market operations, repo and reverse repo rates, CRR, SLR, bank rate, MSF, and LAF to control the money supply and maintain economic stability. These tools help in influencing the cost and availability of credit, thereby impacting economic activities like consumption and investment.

Q. 10. Do you consider a commercial bank ‘creator of money’ in the economy?

Ans.

Yes, a commercial bank is indeed considered a “creator of money” in the economy. Here’s how it works:

Role of Commercial Banks in Money Creation:

(1) Accepting Deposits:

• When you deposit money in a bank, the bank keeps a fraction of it as reserves (as required by the Reserve Bank of India) and lends out the rest. This process is known as fractional reserve banking.

(2)Providing Loans:

• When banks lend money to borrowers, the borrowers receive this money in their bank accounts. Even though the money is lent out, it still remains in the banking system as deposits. This creates new money in the economy.

Example of Money Creation:

Let’s say you deposit ₹10,000 in a bank. If the Required Reserve Ratio (RRR) is 10%, the bank keeps ₹1,000 as reserves and can lend out ₹9,000. The borrower who receives the ₹9,000 loan deposits it in their bank account, and the process continues. The initial deposit of ₹10,000 can eventually result in a much larger increase in the total money supply due to this cycle of lending and depositing.

Money Multiplier Effect:

The total increase in the money supply is determined by the money multiplier, which depends on the LRR. The formula for the money multiplier is:

Money Multiplier = 1\LRR

In this way, commercial banks create money by expanding the money supply through lending activities.

Summary:

Commercial banks play a crucial role in creating money by accepting deposits, keeping a fraction as reserves, and lending out the rest. This process multiplies the initial deposits and increases the overall money supply in the economy.

I hope this explanation helps! If you have any more questions or need further clarification, feel free to ask. 😊

Q. 11. What role of RBI is known as ‘lender of last resort’?

Ans.

Lender of Last Resort:

The Reserve Bank of India (RBI) acts as the “Lender of Last Resort” (LOLR) to provide financial assistance to commercial banks and other financial institutions when they face severe liquidity crises and cannot obtain funds from other sources. This role is crucial for maintaining stability and confidence in the banking system.

Key Points:

(1) Emergency Support:

When banks are unable to meet their financial obligations or face unexpected large withdrawals from depositors, the RBI provides them with funds to ensure they can continue operating.

(2) Preventing Bank Failures:

By lending money to struggling banks, the RBI helps prevent bank failures and maintains trust in the financial system.

(3) Stabilizing the Economy:

The LOLR role helps stabilize the economy by ensuring that banks have sufficient liquidity to function effectively, even during times of financial stress.

How It Works:

• Loans: The RBI provides short-term loans to banks facing liquidity issues. These loans are typically given at higher interest rates to discourage banks from relying on them frequently.
• Collateral: Banks must provide collateral, such as government securities, to obtain these loans from the RBI.

Summary:

The RBI’s role as the “Lender of Last Resort” is to provide emergency financial support to banks during liquidity crises, helping to maintain stability in the banking system and prevent bank failures. This role is essential for ensuring the smooth functioning of the economy, especially during times of financial distress.